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I have been harping for many months that mark-to-market accounting, aka fair-value accounting, will go down as a culprit in the current financial crisis. I have upgraded my view and now think it will go down as one of the worst regulatory changes brought about by accountants in American history. Yes, that's how strongly I feel that it has exacerbated the crisis. I'm not an accountant or a financial analyst but sometimes those outside the field probably have a more neutral view.

Just to be clear, I am not arguing that it is the cause of the crisis! The cause is clearly mortgages given to people that couldn't afford them. I will also note that financial institutions benefitted 'on the way up' from this scheme. But it would have been better if they never benefitted on the way up no more than they suffer on the way down. What mark-to-market is doing is gravely exacerbating the situation.

John Mauldin seems to share my view and comments about it in this week's letter (requires free e-mail sign-up). Let me liberally quote a few of his key paragraphs:

What's a recipe for a perfect financial storm? Let's make a massive amount of bad loans and get them on the books of most of the major financial institutions because they are rated investment grade. Then let's have the loans start to go bad. Throw in some general panic as everyone tries to sell the loans. No one is buying.

Let's make a new rule that you have to mark your illiquid securities to the last price paid by someone desperate to sell. That means that many institutions now have to mark their capital down and that means those pesky rating agencies must by their own rules mark down the ratings of the institutions which of course means that it costs them more to raise capital at a time when they can't get it which means they get lower ratings and so on. It becomes a vicious cycle.

Anyone following the financial firms would easily realize how much of a vicious cycle it is.

In the early 80's, every major US bank was bankrupt because they had loaned Latin American countries far more than their capital they had on their books. The Latin American countries defaulted. If the US banks had been forced to mark to market, they would have all gone down taking the US economy along with them. So, the Fed simply allowed them to carry the loans at book value, offering liquidity and allowing the banks to buy time to make enough money to eventually write off the loans.

Although Mauldin implies that the main benefit would be to let the businesses earn their way back, my main reason is the belief that the assets are better off than market price. Since everything is opaque and complicated, everything is being lumped into the same category and no one wants to touch them. Some institutions will take massive losses and may even go bankrupt but the losses should be far less than the market perception. To see what I mean, consider the cases being reported in the media where prime borrowers are unable to finance their homes. Everything related to housing is being treated the same even though they are not. If the word stereotyping applied to investing, this is it.

It is one thing to require that you mark your stocks or bonds to market values. It is another thing entirely to require all mortgage backed securities, which are extremely complex things, can be very different one from another and which require a lot of time and effort to value, to be priced as though they are all the same.

FASB 157 needs to be amended this week. If Congress can create a new Resolution Trust Corp in a week, the surely the accounting board, with the suggestion of Treasury, can figure out a better way to price illiquid securities.

Too late, I think. Accountants are a slow moving bunch anyway. It's probably too late for the housing problems. However, something needs to be done in the future. There are a lot of so-called level 3 assets which have nothing to do with mortgages and fair value accounting will start causing problems there in the future. Instead of spending time worshipping efficient markets, the accountants and their body should focus their time on trying to develop ways to value illiquid assets. If the accounting framework fails for the level 3 assets, it will may bankrupt the commerical banks--those that avoided the housing problems.

Again, to reiterate, bad assets will result in losses no matter what. I am not suggesting that bad assets should be treated as if they are good; rather, my point is regarding the unfortunate circumstance where everything, including good assets, are lumped into the bad assets and priced based on some depressed market price. Pricing everything based on market price may make sense from an efficient market point of view, but reality is anything but.

8 Response to Mark-to-market Accounting Exacerbating The Collapse

Mark-to-market may have exacerbated the problem (caused by other reasons), but in a way it has acted as a cleansing mechanism. If not for mark-to-market, this whole problem would have been revealed to the public in 5-10 years -- can you imagine how immense the problem would have been then?

I for one, am glad that this mess was revealed to the public sooner than later -- my thanks go to mark-to-market regulation.

I don't think mark-to-market accounting reveals anything. I don't think it has helped investors much. If anything, it has caused investors to flee ALL financial institutions with even a hint of mortgage exposure. It's a sad state of affairs when even the "good ones" get beaten up because bad assets from a competitor forces them to mark down their good illiquid assets to the same price.

Using say book values rather than marks really doesn't delay the problem into the future. Investors would see the reality when losses are borne. It doesn't take 10 years to see mortgage bonds defaulting, with many homeowners unable to pay. You would have seen that as soon as it happened. Even without mark-to-market accounting, the subprime mortgages with poor returns would have tanked anyway.

The only thing you would be missing from a lack of mark-to-market accounting is your inability to figure out what is happening on the balance sheet. Only the poorly performing assets would be detected while others sit there until they default (but as I said above, you would detect it anyway--as soon as mortgage payments are missed.) Things would be a bit more opaque but I would argue that things are opaque right now with mark-to-market accounting. The mark-to-market values cannot be trusted (if you could trust them investors wouldn't be fleeing every mortgage asset and ploughing into short-term govt bonds with near-zero yield.)

To sum up, mark-to-market accounting is not what revealed this crisis. The actual revelation came from missing mortgage payments and homeowners walking away. All mark-to-market has done is to peg the same price on a group of assets, many of which aren't even the same (it's like treating every mortgagee on your street as a high probability of failure simply because the only 3 people with a transaction price on your street actually defaulted).

You can assign a value to a single mortgage that way. But what happens when you combine them into CDOs (much less CDO squared, etc)? The "book value" would depend on whatever projected default rate was built into the model - so what happens if it turns out to be wrong?

You are quite right in saying that the book value (with projected rates) may be wrong. But that's ok. Well, you take a loss or reserve for that. As information becomes available, you start taking losses.

This would be similar to if you held a bond position or owned real estate. If you marked the bond to market, you would get nonsensical results. For instance, it may indicate that you will take principal losses simply because the bond price declined. But it is only a loss if you sold it. Similarly, if companies marked their real estate to market, their balance sheets would be fluctuating. In fact, it is possible to get situations indicating that your key factory is worthless because a competitor's factory went bankrupt. I'm being very simplistic here but the point is similar.

The only downside with this is that it leaves a lot up to the company itself (management) or the auditors. Some may be skeptical of letting management or auditors price it but if you are an investor your fate is in management's and external auditor's hands anyway. If someone wanted to commit fraud they can with or without mark-to-market accounting. So this isn't a big worry for me.

Not relying on marks will also require far greater due dilegence on the part of the buyers.

So it comes down to whether you want to look at it from a glass half-empty point of view; or take a half-full view. Marking to market would yield a half-empty point of view during stressful times. Book value will yield an optimistic scenario during stressful periods.

I don't think marking to market is any more accurate. That's why I don't think it helps. I mean, just look at how practically all assets are being sold off. A good example is CDS on high quality, non-financial, corporations. Yes, default rates will increase due to ecnomic weakening and so forth but some of the numbers being reported by the media don't make any sense. If you owned a CDO consisting of bonds of these corporations, does it mean that this is significantly more risky? I would argue it is not, even though the market is pricing it as if it were.

Anonymous

September 23, 2008 at 3:13 PM

Mark to market accounting should be merged with "amortization" concepts when dealing with assets that have a measurable anticipated life span. In other words, if an asset (pool) is expected to have an economic lifespan of 10 quarters, then when its market value increases or decreases by $1,000,000, its book value shoud only be marked up or down by 10% of the total change during the current quarter. Then, as the expected life span expands or contracts, adjustments to "true up" the previous quarters' markings can be made as a separate line item. Having lost a job at a very profitable company that was brought down when FAS 157 was implemented a few years ago, I have personal experience with the havoc wreaked by mark to market accounting. It exaggerates gains on the way up and it exaggerates losses on the way down.When combined with the ratings industry it is death to any valid measurement of "worth" when dealing with any long-term asset that, when held to maturity, would provide a perfectly respectable average yield over time.MARK TO MARKET ACCOUNTING RULES HAVE MADE ALL LONG-TERM FINANCIAL ASSETS INTO UNMARKETABLE "HOT POTATOES" AND FAS 157 SHOULD BE BANNED FROM ANY CIVILIZED CULTURE.

Thanks for the insight anonymous. Hopefully the accounting board will reform the system. It's too late make abrupt changes but hopefully it can be altered to avoid bringing down companies in the future.

I'm sorry to hear about your job loss. I hope you have found another job; if not, all the best with your job hunting. I know it must be very difficult in the present environment. Good luck...

sc

September 24, 2008 at 9:57 AM

I could not disagree more. Leverage and inertia caused this problem. Values change through time and you have to know them if you are going to take action to protect your capital. If you "hope" things are going to get better you are going to get carried out at some point, especially with 20x leverage!

With pure accrual, people put their faith in mean reversion yet are so risk averse that if you asked them to buy now they would say you are nuts.

How would you like your stock portfolio to be reported on book value? You'd be holding LEH at 30 as it goes into the toilet.

The leverage is not necessarily out of whack. It's a bit higher than the past but that's how these firms operate. If investment banks had a leverage like a typical bank or insurance company, they wouldn't exist. Shareholders would never invest in them and employees would not make as much money as they do.

The problem is mispricing of risk. Leverage simply amplifies the losses but that's the nature of this business. It's the same thing with the monoline bond insurers. The fact that their leverage is 50x to 100x is not the problem. In fact, Berkshire Assurance is also using 50x+ leverage. The problem is mispricing risk.

As for your comment about shareholders preferring mark-to-market value over book value, it depends on the person. If you are a short-term investor you would probably prefer mark-to-market values but if you are a long term investor, book value (adjusted down only if impairment is likely) is perfectly fine. Almost everything else on the balance sheet are book values. Real estate. Inventory. Goodwill. Intangibles. How much of this is marked to real time values? Almost none.